6. bond valuation

Chapter 7
The Valuation
and
Characteristics
of Bonds

Copyright © 2011 Pearson Prentice Hall.
All rights reserved.

Learning Objectives

1. Distinguish between different kinds of bonds.
2. Explain the more popular features of bonds.
3. Define the term value as used for several different
purposes.
4. Explain the factors that determine value.
5. Describe the basic process for valuing assets.
6. Estimate the value of a bond.
7. Compute a bondholder’s expected rate of return.
8. Explain three important relationships that exist in
bond valuation.

© 2011 Pearson Prentice Hall. All rights reserved. 7-2

Slide Contents

Principles used in this Chapter
1. Types of Bonds
2. Bond Terminology
3. Bond Valuation
4. Bond Yield
5. Bond Valuation: Important Relationships


Principles Applied in
this Chapter

 Principle 3:
Money has time value
 Principle 3:
Risk requires reward
 Principle 4:
Market prices are generally right


Bonds

 Meaning: Type of debt or long-term
promissory note, issued by a borrower,
promising to its holder a predetermined and
fixed amount of interest per year and
repayment of principal at maturity.
 Issuers or Borrowers: Corporations, US
Government, State and Local Municipalities.


1. Types of Bonds

 Debentures
 Subordinated Debentures
 Mortgage Bonds
 Eurobonds
 Convertible Bonds


Debentures

 Debentures are unsecured long-term
debt.
 For issuing firm, debentures provide the
benefit of not tying up property as
collateral.
 For bondholders, debentures are more
risky than secured bonds and provide a
higher yield than secured bonds.


Subordinated Debenture

 There is a hierarchy of payout in case
of insolvency.
 The claims of subordinated debentures
are honored only after the claims of
secured debt and unsubordinated
debentures have been satisfied.


Mortgage Bond

 Mortgage bond is secured by a lien on
real property.
 Typically, the value of the real property
is greater than that of the bonds issued.


Eurobonds

 Securities (bonds) issued in a country
different from the one in whose
currency the bond is denominated.
 For example, a bond issued by an
American corporation in Japan that
pays interest and principal in dollars.


Convertible Bonds

 Convertible bonds are debt securities
that can be converted into a firm’s stock
at a pre-specified price.


2. Bond Terminology

 Claims on assets and income
 Par value
 Current yield
 Coupon interest rate
 Maturity
 Call provision
 Indenture
 Bond ratings


Claims on Assets and Income

 Seniority in Claims: In the case of
insolvency, claims of debt, including
bonds are honored before those of
common or preferred stock.


Par Value

 Par value is the face value of the bond,
returned to the bondholder at maturity.
 In general, corporate bonds are issued at
denominations or par value of $1,000.
 Prices are represented as a % of face value.
Thus a bond quoted at 112 can be bought at
112% of its par value in the market. Bonds
will return the par value at maturity,
regardless of the price paid at the time of
purchase.

Coupon Interest Rate

 The percentage of the par value of the bond
that will be paid periodically in the form of
interest.
 Example: A bond with a $1,000 par value
and 5% coupon rate will pay $50 annually
(.05*1000) or $25 (if interest is paid semi-
annually).


Maturity

 Maturity of bond refers to the length of
time until the bond issuer returns the
par value to the bondholder and
terminates or redeems the bond.


Call Provision

 Call provision (if it exists on a bond) gives
corporation the option to redeem the bonds
before the maturity date. For example, if the
prevailing interest rate declines, the firm may
want to pay off the bonds early and reissue at
a more favorable interest rate.
 Issuer must pay the bondholders a premium.
 There is also a call protection period where
the firm cannot call the bond for a specified
period of time.

Indenture

 An indenture is the legal agreement between
the firm issuing the bond and the trustee who
represents the bondholders.
 It provides for specific terms of the loan
agreement (such as rights of bondholders
and issuing firm).
 Many of the terms seek to protect the status
of bonds from being weakened by managerial
actions or by other security holders.


Bond Ratings

 Bond ratings reflect the future risk potential of
the bonds.
 Three prominent bond rating agencies are
Standard & Poor, Moody’s, and Fitch Investor
Services.
 Lower bond rating indicates higher probability
of default. It also means that the rate of return
demanded by the capital markets will be
higher on such bonds.


Table 7-1


Favorable Factors affecting
Bond Rating

 A greater reliance on equity as opposed
to debt in financing the firm
 Profitable operations
 Low variability in past earnings
 Large firm size
 Minimal use of subordinated debt


Junk Bonds

 Junk bonds are high-risk bonds with
ratings of BB or below by Moody’s and
Standard & Poor’s. Junk bonds are also
referred to as high-yield bonds as they
pay high interest rate, 3-5% more than
AAA rated bonds.


3. Valuing Bonds

Defining Value
 Book value: Value of an asset as shown on a firm’s
balance sheet.
 Liquidation value: The dollar sum that could be
realized if an asset were sold individually and not as
part of a going concern.
 Market value: The observed value for the asset in
the marketplace
 Intrinsic or economic value: Also called fair value—
the present value of the asset’s expected future cash
flows.

Value and Efficient Market

 In an efficient market, the values of all
securities at any instant fully reflect all
available public information.
 If the markets are efficient, the market
value and the intrinsic value will be the
same.


What Determines Value?

 Value of an Asset = Present value of its
expected future cash flows using the
investor’s required rate of return as the
discount rate.
 Thus value is affected by three elements:
 Amount and timing of the asset’s expected future
cash flows
 Riskiness of the cash flows
 Investor’s required rate of return for undertaking
the investment

Bond Valuation

 The value of a bond (V) is a combination of:
 C: Future expected cash flows in the form of
interest and repayment of principal
 n: The time to maturity of the loan
 r: The investor’s required rate of return


Equation 7-1


Typical cash flows on a Bond
(for Corporation)

Time Cash flow
0 Cash inflow from Bond Issue
1–Maturity Pay Interest
Maturity Repay Principal

Exceptions: Bankruptcy, Bond Recalled and
paid off before the due date, Mergers and
acquisitions.

Typical cash flows on a Bond (for
bondholder)

Time Cash flow
O Pay for bond (Buy)
1–Maturity Receive Interest
Maturity Receive Par value back

Exceptions: Bankruptcy, Bond Recalled, Bond
sold by investor in the market before maturity
date, Mergers & acquisitions.

Example on Bond Valuation

 Consider a bond issued by Toyota with
a maturity date of 2010 and a stated
coupon of 4.35%. In December 2005,
with 5 years left to maturity, investors
owning the bonds are requiring a 3.6%
rate of return.


Toyota Bond Example

 Step 1 (CF): Estimate amount and timing of
the expected future cash flows:
 Annual Interest payments
= .0435 × $1,000 = $43.50 every year for five
years
 The par value of $1,000 to be received in 2010


Summary of Cash Flows
(For One Bond)

Time Bondholder Corporation
0 Price = ? Price = ?
1–5 $43.5 –$43.5
5 +1,000 –1,000


Toyota Bond Example

 Step 2 (r) Determine the investor’s
required rate of return by evaluating the
riskiness of the bond’s future cash
flows. Remember the investors required
rate of return equals the risk free rate
plus a risk premium. Here, the required
rate of return (r) is given as 3.6%


Toyota Bond Example

 Step 3: Calculate the intrinsic value of
the bond.
 Bond Value
= PV (Interest, received every year)
+ PV (Par, received at maturity)


Toyota Bond Example

= PV ($43.5, for 5 years, r = 3.6%)
+ PV ($1000 at year 5, i = 3.6%)
= PV of Annuity (A = 43.5; N = 5; r = 3.6%)
+ PV of single cash flow
(FV = $1,000, N = 5, i = 3.6%)
= $195.84 + $837.73
= $1,033.57


4. Bond Yields

Yield to Maturity (YTM)
 YTM refers to the rate of return the investor
will earn if the bond is held to maturity. YTM
is also known as bondholder’s expected rate
of return.
 YTM = Discount rate that equates the present
value of the future cash flows with the current
market price of the bond.


Bond Yields

To find YTM, we need to know:
(a) current price (P)
(b) time left to maturity (n)
(c) par Value and (M)
(d) annual interest payment (C)
 Formula = C + (M-P)/n
 (M+P)
2

Current Yield

 Current yield is the ratio of the interest payment
to the bond’s current market price.
 Current Yield = Annual interest payment/
current market price of the bond
Example: The current yield on a $1,000 par
value bond with 8% coupon rate and market
price of $700
= $80 / $700 = 11.4 %


Total Yield

 Total Yield from Bond = Current Yield
+ Capital gain/loss from sale of bond.
 Thus in the previous example, if the bond was
bought for $700 and sold for $725.

Total Yield = 80 + (725 – 700)
= $105 or 105/700
= 15%


5. Bond Valuation: Three
Important Relationships

Relationship #1
 The value of a bond is inversely related to
changes in the investor’s present required
rate of return (the current interest rate).
 As interest rates increase (decrease), the
value of the bond decreases (increases).


Bond Valuation: Three Important
Relationships

Relationship #2
 The market value of a bond will be less than
the par value if the investor’s required rate of
return is above the coupon interest rate.
 Bond will be valued above par value if the
investor’s required rate of return is below the
coupon interest rate.


Discount Bonds

 The market value of a bond will be
below the par when the investor’s
required rate is greater than the coupon
interest rate. These bonds are known
as discount bonds.


Premium Bonds

 The market value of a bond will be
above the par or face value when the
investor’s required rate is lower than the
coupon interest rate. These bonds are
known as premium bonds.
 If investor’s required rate of return is
equal to the coupon interest rate, the
bonds will trade at par.


Bond Valuation: Three Important
Relationships

Relationship #3
 Long-term bonds have greater interest rate
risk than do short-term bonds.
 In other words, a change in interest rate will
have relatively greater impact on long-term
bonds.


Main Risks for Bondholders

 Changes in current Interest rates (if interest
rates rise, the market value of bonds will fall)
 Default Risk (this may mean no or partial
payment on debt as in bankruptcy cases)
 Call Risk (If bonds are called before maturity
date)… bond are generally called when
interest rates decrease. Thus investors will
have to reinvest the money received from
corporation at a lower rate.


Figure 7-1


Figure 7-2


Figure 7-3


Figure 7-4


Key Terms

 Bond  Debenture
 Book Value  Discount bond
 Callable Bond  Eurobond
 Call protection  Expected rate of
period
return
 Coupon interest rate
 Fair value
 Current Yield


Key Terms

 High-yield bond  Liquidation value
 Indenture  Discount bond
 Interest rate risk  Eurobond
 Intrinsic value  Expected rate of return
 Junk bond  Fair value


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